Advanced Portfolio Thinking: Absolute Returns

UK investors don’t have to believe blindly in the notion that shares and bonds always increase in value. They absolutely don’t and in reality key asset classes can be a dreadful idea, not just for a few years but for decades. This fact should put you on your guard and make you think long and hard about conserving your wealth as well as where you can make future profits.

The term absolute returns is hugely popular with fund marketing types who love the promise of an absolute positive return (capital gain) in any kind of market. The problem, immediately apparent to anyone with a modicum of common sense, is that as an ideal it sounds a bit like modern alchemy.

‘Make money all the time!’ is a catchy advertising line but not terrifically easy to achieve in the grim, grey world of investing reality.

On balance you need to be cynical about the claims of absolute returns. Many fund managers fail to deliver on this ideal, with most offering a pale alternative — their investors don’t lose quite so much money on the way down and don’t make so much on the way up!

In reality (too) many absolute returns funds should be marketed as ‘Not quite so volatile’, but that’s obviously less catchy as a title.

But don’t let that slightly trite remark about volatility (how much a share price moves up and down on a regular basis) obscure the fact that the idea of absolute returns is useful. If a fund manager can deliver most of the returns of the wider market but with much less volatility, that may be useful for investors looking to ‘smooth’ their returns.

The ideal of investing in a fund with a high level of liquidity (cash) in order to conserve capital may also be very attractive to certain investors. Nothing’s wrong with the aim of preserving your capital come what may.

Crucially, the idea of absolute returns forces managers to think creatively about investing. Instead of just expecting a market to keep on going up (where the fund is essentially long the market), an absolute returns fund manager explores alternative strategies, which may include new asset classes or making money from falling markets.

In essence, when it works properly, absolute returns makes managers work harder to produce returns come what may. On balance that’s a good idea and one that you can copy via your investing techniques. Just don’t expect it to work all the time.

All that strenuous activity by the investment manager (the need to make money in falling markets, using alternative assets) to make sure that you conserve your capital introduces two specific risks:

That the manager doesn’t succeed! In other words, the person makes the wrong calls at the wrong time in the market. Too much activity doesn’t necessarily equate to constant success.

That constant trading and energetic fund management costs you extra money. Fees on absolute returns funds can hit the roof (with charges of 2 per cent or more standard in the sector) with the inevitable knock-on effect on your wealth.

High fees are just about palatable if you’re invested in a wunderkind manager, but they’re a recipe for financial ruin if your manager undershoots the market. At that point you’re hit with a double whammy of poor returns and high costs.